9 Key Financial Ratios Every Indian Investor Must Know

Navigating the Indian stock market requires more than just tracking share prices. To truly understand a business’s financial health and long-term potential, you need to look under the hood. The key to this is financial ratios.

Think of financial ratios as a doctor’s report for a company. They are simple calculations based on a company’s financial statements—like the Profit & Loss Statement and Balance Sheet—that reveal its strengths, weaknesses, and overall performance. By mastering a few key ratios, you can transform from a passive spectator into an informed analyst, making smarter and more confident investment decisions.

Here are nine of the most important financial ratios, grouped into four key categories, that every Indian investor should have in their toolkit.

Key Takeaways

• Valuation Ratios (P/E, P/B): Help determine if a stock is potentially cheap or expensive at its current price.
• Profitability Ratios (NPM, ROE, ROCE): Show how effectively a company converts revenue into actual profit.
• Solvency Ratios (D/E, ICR): Reveal a company’s financial risk and its ability to manage and repay its debts.
• Efficiency Ratios (Asset & Inventory Turnover): Measure how well a company uses its resources to generate sales.

1. Valuation Ratios: Are You Paying the Right Price?

Valuation ratios help you assess whether a stock’s current market price is fair, undervalued, or overvalued relative to its financial performance.

Price-to-Earnings (P/E) Ratio

The P/E ratio is perhaps the most widely used valuation metric. It tells you how much you are paying for every one rupee of a company’s earnings.

• Formula: Market Price per Share / Earnings per Share (EPS)
• What it means: A P/E of 25 indicates you are paying ₹25 for every ₹1 of profit the company generates.
• Interpretation:
  • High P/E: May suggest the stock is overvalued, or that investors have high expectations for future growth.
  • Low P/E: Could mean the stock is undervalued, or the company is facing underlying business challenges.
  • Crucial Context: Always compare a company’s P/E with its peers in the same industry. A P/E of 30 might be high for a steel company but perfectly normal for a high-growth tech company.

Price-to-Book (P/B) Ratio

The P/B ratio compares a company’s market capitalization to its “book value.” Book value is the net asset value of a company (Total Assets - Total Liabilities).

• Formula: Market Price per Share / Book Value per Share
• What it means: A P/B of 2 means you are paying ₹2 for every ₹1 of the company’s net assets.
• Interpretation:
  • A P/B ratio below 1 can sometimes indicate an undervalued stock, as the market values it at less than its on-paper worth.
  • This ratio is especially useful for asset-heavy industries like banking, manufacturing, and infrastructure.

2. Profitability Ratios: How Efficiently Does the Company Generate Profits?

These ratios measure a company’s ability to generate profits from its sales, assets, and capital.

Net Profit Margin (NPM)

This ratio reveals the percentage of revenue left after all expenses, including taxes and interest, have been deducted. It is a pure measure of a company’s profitability.

• Formula: (Net Profit / Total Revenue) * 100
• What it means: An NPM of 15% means the company earns a net profit of ₹15 for every ₹100 in sales.
• Interpretation: A higher and more consistent NPM is generally better, indicating efficient management and strong pricing power.

Return on Equity (ROE)

ROE is a vital ratio for shareholders, measuring how effectively a company uses their invested capital to generate profits.

• Formula: (Net Profit / Total Shareholders' Equity) * 100
• What it means: An ROE of 20% means the company generated ₹20 in profit for every ₹100 of shareholders’ equity.
• Interpretation: An ROE of 15-20% or higher is generally considered good. However, always check if a high ROE is artificially inflated by excessive debt.

Return on Capital Employed (ROCE)

ROCE offers a broader view of profitability by considering all capital used by a company, including both debt and equity.

• Formula: EBIT / (Total Assets - Current Liabilities) * 100 (where EBIT is Earnings Before Interest and Tax)
• What it means: It shows how efficiently a company is using all its available capital to generate operating profits.
• Interpretation: A high and stable ROCE indicates efficient use of capital. It is excellent for comparing companies, especially in capital-intensive sectors.

3. Solvency Ratios: How Well is the Company Managing Its Debt?

These ratios help you assess a company’s financial leverage and its ability to meet its long-term debt obligations.

Debt-to-Equity (D/E) Ratio

This ratio compares a company’s total debt to its total shareholders’ equity, providing a direct measure of its financial leverage.

• Formula: Total Debt / Shareholders' Equity
• What it means: A D/E ratio of 1.5 means the company has ₹1.5 of debt for every ₹1 of equity.
• Interpretation:
  • Less than 1: Generally considered safe, indicating low reliance on borrowed funds.
  • More than 2: Can be a red flag, suggesting high financial risk, though this can be normal for certain industries like banking or infrastructure.

Interest Coverage Ratio (ICR)

The ICR measures a company’s ability to pay the interest on its outstanding debt using its operating profits.

• Formula: EBIT / Interest Expense
• What it means: An ICR of 5 indicates the company’s operating profit is 5 times its interest expense for the period.
• Interpretation: A higher ratio is always better. An ICR below 1.5 is a major warning sign, as it suggests the company may struggle to meet its interest payment obligations.

4. Efficiency Ratios: How Effectively is the Company Using Its Resources?

Efficiency ratios, or turnover ratios, measure how well a company utilizes its assets and liabilities to generate sales.

Inventory Turnover Ratio

This ratio shows how many times a company has sold and replaced its inventory during a specific period.

• Formula: Cost of Goods Sold / Average Inventory
• What it means: A high ratio indicates that the company is selling its products quickly and managing its stock efficiently.
• Interpretation: A high turnover is generally positive, suggesting strong sales. A very low turnover might indicate overstocking, obsolete inventory, or weak sales. This is most relevant for manufacturing and retail businesses.

Asset Turnover Ratio

This ratio measures how efficiently a company uses its total assets to generate revenue.

• Formula: Net Sales / Average Total Assets
• What it means: An asset turnover ratio of 1.2 means the company generates ₹1.2 in sales for every ₹1 of assets it owns.
• Interpretation: A higher ratio is preferable, as it implies the company is getting more revenue from its asset base.

Conclusion: From Ratios to Rationale

By regularly using these nine financial ratios, you can build a comprehensive and nuanced picture of a company’s financial health. They empower you to look beyond market hype and stock price fluctuations to make investment decisions based on solid fundamentals.

Remember, no single ratio tells the whole story. The real power comes from using them in combination and comparing them across industry peers and historical trends. Start incorporating them into your research process, and you’ll be well on your way to becoming a more discerning and successful investor.

This article is for informational purposes only and does not constitute investment advice. Please conduct your own thorough research before making any investment decisions.